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Muni Fund Ride Isn't Entirely Bad News

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For portfolio managers of municipal bond funds, the past several months haven’t been for the faint of heart. Still, muni fund managers report mixed experiences in riding out the prolonged flood of outflows.

At Pioneer Investments in Boston, the investment-grade side has seen outflows. That falls in line with the industry at large. But the high-yield fund has seen positive flows for roughly the past eight weeks, according to Timothy Pynchon, the fund’s manager.

For the muni bond funds at Thornburg Investment Management in Santa Fe, N.M., outflows were substantially lower than the industry average of almost 9%, according to Christopher Ryon, a portfolio manager there. He declined to say how much they were down at Thornburg.

“We were lucky,” Ryon said. “We tried to make sure that, as managers, we were out talking to shareholders, addressing their concerns about what was driving the markets higher.”

By almost every account, the flood of outflows from muni mutual funds is slowing substantially after 27 straight weeks. Muni funds that report their numbers weekly saw net outflows of $108 million for the week ending May 18, according to Lipper FMI.

That number has fallen considerably from just two weeks earlier, when investors withdrew nearly $800 million.

But muni bond funds saw inflows of $38 million for the week ending May 11, according to the most recent numbers available from the Investment Company Institute.

Likewise, assets for funds that report weekly climbed to $316 billion, Lipper data showed, from $314.1 billion in assets in the week ended May 11. The value of the funds’ holdings rose by almost $2.1 billion. And net asset values gained for the seventh straight week.

Portfolio managers said that “headline risk” after some predictions of rampant defaults across the industry contributed significantly to the outflows.

The risk spooked less-sophisticated investors into pulling their money from muni funds, they said. Since mid-November through the week of May 18, municipal funds have seen a hemorrhaging of almost $49 billion, Lipper numbers showed.

Individual investors in municipals represent mostly a range of high-net-worth individuals. Generally, lower-level high-income investors invest in muni bond funds, while high-net-worth investors on the upper end of the scale buy individual bonds. And many of the more sophisticated investors have been purchasing individual bonds in an attempt to take advantage of buying opportunities created in the wake of market uncertainty caused by bad news about munis.

Around February, investors noticed how spreads between the taxable and tax-exempt markets narrowed, said John Mousseau, a portfolio manager who runs the muni desk at Cumberland Advisors. While yields firmed on the taxable side, they eased for tax-exempts, he said, creating an appetite for tax-exempts among a lot of traditionally taxable buyers.

“Accounts that had been long-term investors, who’d been through a number of interest rate cycles, could see that this was clearly a liquidity-driven and not a credit-driven event,” Mousseau added.

Portfolio managers also noticed new buyers throughout the period of liquidations. Hedge funds and, more noticeably, taxable corporate funds and other crossover buyers entered the market as nontraditional muni investors around January and February, when the rates were very cheap. Tax-exempt muni yields were higher at the time of trading than taxable yields for similarly rated paper.

“So, if you’re a taxable manager,” Pynchon said, “why would you continue to buy corporate debt at greater prices than you could buy the same security in municipal debt?”

For some fund managers, the outflows prompted a change in long-term strategy, he said. But restructurings differed among individual fund families and fund managers, leading to results that varied from fund to fund.

“If you’re adding paper, and you think you’re heading in the right direction, and all of a sudden you experience enormous redemptions, that’s going to interrupt any strategy,” Pynchon said.

Thornburg managers looked at the market and thought a lot of the concerns were based more on hyperbole than facts, Ryon said. They decided to take on more risk at the time. Going into September, some of the firm’s bond funds were around 10% in cash. In the fourth quarter, they lowered the exposure considerably.

“We probably took the intermediate fund’s duration from about seven and a half years up to nine years,” Ryon said. “You must remember that in the fourth quarter of 2010, the yield curve steepened by almost 70 basis points. A significant amount of the rate increase we saw came in the long end of the market. So, it made it much more compelling for that fund to take on more risk.”

He’s happy with the results. Since the end of 2010 through mid-May, Thornburg’s intermediate-term portfolio is up about 3.4%, Ryon said. Its limited-term portfolio is up around 2.9%, and its strategic fund is up about 3.5%, he added.

Pioneer’s Pynchon said he’s adding as much paper to his high-yield portfolio as he can right now. He has noticed how the market has forced good-quality paper to be priced down to very discounted levels.

“In two to three months, we’re not going to see them again,” Pynchon said, “because we’re going to start to see significant cash inflows and the chase will be on for all the paper that’s been ignored for the last six months.”

If liquid municipal exchange-traded funds are any indicator — and the industry often sees them that way — those cash inflows may well be coming.

Over the last several months, liquid ETFs have recovered roughly two-thirds of their losses since last fall, Citi strategist George Friedlander wrote in his most recent report.

In addition, ETFs are trading at sizeable premiums to their net asset values. That’s important because it’s an indicator of retail interest in muni bonds. Citi’s statistical analysis showed that the correlation between muni fund flows and changes in exchange-traded funds’ NAVs is quite high. And if the flows’ data series is shifted forward, the correlation is even higher.

“This proves that the change in the NAV premium for liquid ETFs leads the change in the trend in muni fund flows by three to four weeks,” Friedlander wrote. “If history repeats itself, we should see an improvement in muni inflows in the weeks to come.”